2016-05-24

SocGen Estimates Bank Losses 60 pc of Capital

China is still leveraging up rapidly, with its nonfinancial debt up to 250% of GDP [ZH: realistically 350%]. The corporate sector and capital market liberalisation that the authorities are pushing for has begun to destabilise the debt dynamics. The beginning of debt restructuring for SOEs, the biggest borrowers and underperformers, brings closer the prospect of bank restructuring – a scenario we think that has a probability of more than 50% over the medium term.

As SOE restructuring progresses, it will also become more apparent that Chinese banks need to be rescued.

We estimate that the total losses in the banking sector could reach CNY8 trillion, equivalent to more than 60% of commercial banks’ capital, 50% of fiscal revenues and 12% of GDP. The actual tally may still be years away, but could be more sizeable if problems continue to grow.

China may still be able to dodge an economic crisis while restructuring its corporate and banking system, but the margin for error will be uncomfortably slim.

If that forecast is even in the ballpark, the margin for success is slim. China will need a white swan to avoid the pain of restructuring. For instance, later in the article it notes SocGen estimates the losses on NPL after recovery could be almost 5x bank capital.

The solution to the currency issue might be a mix of two: basically, banks selling the PBoC’s dollars (obtained from FXR injection) to dampen the depreciation pressure on the renminbi caused by the expansion of the PBoC’s balance sheet, which is a result of the PBoC’s acquisition of CGBs issued for bank recapitalisation. However, it is impossible to make the mix just right so that there is no or little impact on the currency – this would require an unrealistically high degree of PBoC control over banks and/or an incredible amount of foresight.

The bottom line is that the government bail-out programme could be designed in a way to greatly limit its impacts on currency and capital account stability. Such designs seem to exist in theory, but would be very difficult to realise in the real world. We think that greater currency flexibility would probably be another major consequence that the authorities need to accept alongside bank restructuring.

This is the point made here over the years. The credit is the inflation. Either the debt is allowed to default and it falls in value, which is deflation and leads to a full blown recession in China, or the central bank monetizes existing credit and the value of the currency falls. There's no free lunch anymore. Outside of white swans (at this point that includes a surprise privatization wave) there will be a very steep bill to be paid and the most logical conduit is the currency as there is already political and economic pressure in favor of depreciation.

China favors the slow approach:

Being slow and gradual means that policymakers will most likely continue to adjust the pace of defaults and restructuring by offering (targeted) credit stimulus from time to time and, if needed, topping up financial support for failing SOEs and/or banks. This approach would also force relatively stronger banks to pay for incremental NPL disposals with their profits, which is essentially asking banks’ existing shareholders to bear some of the further cost of debt restructuring.

If China is successful, it will take much longer than expected. If it takes upwards of a decade, the country is going to be slamming headfirst into the demographic wall. By 2025, the 20-24 age cohort will be almost 30% smaller than the 35-39 cohort, which is the cohort currently engaged in family formation. In markets such as housing, China will have turned Japanese.

Steve Keen's simple debt model shows that as soon as credit growth slows and definitely if it drops to the rate of GDP growth (stabilizing the debt-to-GDP ratio), economic growth will tumble, possibly into full blown recession. China Can't Go On Like This

Finally, while China could use a white swan, the world is creating new problems, such as a potential trade conflict with the United States.